It’s been interesting to watch the analysts change their positions over the course of the last few months. Two of my favorite analysts Andrew Garthwaite at Credit Suisse and Teun Draaisma at Morgan Stanley came into the year with remarkably similar outlooks to my own: the economy would remain strong in H1, but would weaken as the year wore on. Both were much more bearish on the full year outlook than most other analysts on Wall Street. Interestingly, both of them folded on their bearish outlooks as the equity markets chugged higher into April. At that time, I was revising my H1 outlook, building my first short positions in two years and becoming more bearish as the problems in Greece appeared like a true game changer. A few months later Draaisma and Garthwaite are looking terribly wrong, but Garthwaite isn’t swaying from his bullish outlook. In a recent note he provided 5 reasons to remain bullish. Perhaps he will redeem himself:
1) Market is too pessimistic on global macro outlook: the collapse in bonds yields, along with this week’s decline in the gold price and yesterday’s sell-off in the Australian dollar versus the Yen (7%), suggests that markets are discounting a big deflationary shock. Yet, we do not see this. All the best lead indicators are strong, though they will likely roll-over owing to stock market weakness. The global PMIs are consistent with 4% GDP growth (see page 5 for all charts) and the best two lead indicators of US growth – ISM new orders and consumer confidence expectations – are consistent with growth about 3%. Our economists forecast global GDP of 4.4% next year (2.4% in Europe and 2.9% in the US).
2) Valuation: The US equity risk premium (ERP) is 6.1% if we just use two-year forward IBES numbers and then revert earnings to trend (see Figure 7 below). The long-run average ERP is 3.5%, while our target (or warranted) ERP is 4.5% (the warranted equity risk premium depends on ISM and credit spreads – and assumes a modest deteriorating in both: ISM falling to 55 from 60 and BAA spreads widening to 3% from 2.4%- clearly if we were assuming a recession then ISM would fall to 40 and the BAA spread widen to 5% and the target equity risk premium would rise to 6.2% but as stated already we are not assuming a recession). Even if we revert S&P 500 reported earnings back to their post-1920 trend of $64 (compared to 12-month forward operating earnings of $87.5), the ERP is now 4.5%, almost at our target level.
3) We note that the CDX HY spread at 670bps, is only 0.4 standard deviations above its average, the same level it was at when the S&P 500 was at 1,300. Furthermore, the 5 year / 5 year forward inflation rate is 2.2%, versus a crisis low of nearly zero.
4) Global earnings revisions are at an all-time high (see Figure 23 below). Consensus revenues estimates are, we think, still too low. For Europe as a whole consensus revenue is 5% below nominal GDP in 2009 and 2010 when aggregated and more so for cyclical sectors. Additionally, the weakness of the Euro, if it hits €/$1.20, should directly and indirectly add nearly 14% to European EPS as well as 1% to GDP. To gauge how worried the markets are about earnings, we can look at dividend swaps market, which are discounting a 13% decline in DPS between end 2009 and 2013 in Continental Europe (and a 4% rise in the UK). This seems too pessimistic too us.
5) Investors are still conservatively positioned we think. Mutual funds have 45% of their total assets in equities compared to a long-run average of 51%. Money market funds are still 20% of market cap (versus a long-run average of 18%). Since the low in the equity market, we have seen retail buy 99bn of bonds, while they sold $88bn of equities.
Source: Credit Suisse
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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